On March 9, 2009, the Supreme Court agreed to review Jones v. Harris Associates, L.P., a Seventh Circuit decision that rejects the Gartenberg standard in litigation under §36(b) of the Investment Company Act of 1940 (the “1940 Act”) and adopts a new test for reviewing advisory fee challenges under §36(b). Petitioner (a fund shareholder) is asking the Supreme Court to determine that the Seventh Circuit “erroneously held, in conflict with the decisions of three other circuits, that a shareholder’s claim that the fund’s investment adviser charged an excessive fee—more than twice the fee it charged to funds with which it was not affiliated—is not cognizable under §36(b), unless the shareholder can show that the adviser misled the fund’s directors who approved the fee.” The case will be heard and decided in this term of the Supreme Court, which opens on October 5, 2009.
In Gartenberg v. Merrill Lynch Asset Management, 694 F. 2d 923 (Second Circuit, 1982), the Second Circuit analyzed §36(b) and created a framework for analysis that has served as the starting point for interpreting a fund adviser’s fiduciary duty with respect to the reasonableness of the advisory fees it charges to the fund or funds it advises (and which it may also have created and for which it may have selected the directors or trustees responsible for managing the fund or funds and ensuring compliance with the 1940 Act). The Gartenberg test is essentially “whether the fee schedule represents a charge within the range of what would have been negotiated at arm’s-length in the light of all of the surrounding circumstances.” 694 F. 2d at 928. The court listed six “nonexclusive” factors that it considered germane to the analysis of the reasonableness of advisory fees. Since 1982, a number of courts of appeal and district courts have indicated approval of the Gartenberg analytical framework, and the Seventh Circuit’s recent explicit rejection of this approach presents an unusual split among the circuits that the Supreme Court has decided to address.
After the Supreme Court granted certiorari in the Jones case, in April 2009, the Eighth Circuit reexamined the usefulness of the Gartenberg approach to §36(b) and concluded that the factors enumerated in that decision “provide a useful framework for resolving claims of excessive fees, notwithstanding the substantial changes in the mutual fund industry that have occurred in the intervening years.” Gallus v. Ameriprise Financial, 561 F. 3d 816 (Eighth Circuit, 2009). Interestingly, the Court in Gallus married the approach expressed by the Seventh Circuit in Jones with the multifactored analysis of Gartenberg, stating that “[w]e believe that the proper approach to §36(b) is one that looks to both the adviser’s conduct during negotiation and the end result itself.” The Court went on to hold that the district court had erred in holding that no §36(b) violation occurred simply because Ameriprise’s fee passed muster under the Gartenberg standard. Rather, it should have also considered the fund board’s duty to compare the fees charged by the adviser to its institutional clients to those charged to its mutual fund clients, and more important, whether the adviser had omitted, disguised or obfuscated information presented to the fund’s board about the fee differences between types of clients. The case was remanded to the district court to consider the material questions of fact on this issue.
Commentators have noted that no investor has obtained a verdict against an investment adviser in the more than 25 years since Gartenberg. In addition to awaiting the Supreme Court’s decision in Jones, it will be interesting to see if Gallus and his fellow shareholders become the first to successfully challenge what has become a “rubber stamp” approval process for most mutual funds.1